Summary

Covered calls can enhance income, but also make sense during accumulation.

How significant an effect can be expected over a relatively short timeframe?

There have been a number of recent articles here on Seeking Alpha demonstrating various approaches to enhancing income by using various option strategies. In this short piece, I take a look at one of the favorite DGI stocks and how the traditional approach can be combined with covered calls to increase income more quickly.

Some Initial Thoughts on HCP, Inc.

HCP, Inc. (NYSE:HCP) has been somewhat troubled recently. The legal issues of one of its largest lessors, HCR Manor Care, and the subsequent rate concessions have had a significant (though perhaps overdone) negative influence on HCP the stock. As I write this on Thursday, January 28, HCP has taken a major beating, falling another 5% Wednesday, down from a recent high of $39.25 on the 5th and more than $13 off its 52-week high of $48.61, set last February. After the close, HCP declared a somewhat disappointing dividend raising just $0.04 annually to $0.575 per quarter.

Even so, HCP remains a popular Dividend Aristocrat here on Seeking Alpha, having delivered a steadily increasing income stream for 30 years. My own position presently consists of 812.7870 shares long (and DRIPing) and eight April $35 (covered) calls short. With the next dividend about to be declared, I decided to take a look at how DRIPing and writing covered calls may affect the position over a period of years.

Effects of Dividend Re-Investment

At the current rate of $0.575 per share, my position generates $467.35 per quarter. That purchases about 13 new shares with no additional commission or fees. As a result, I can expect to increase my position by about 100 shares every two years.

Since it's almost a tradition here on Seeking Alpha, here are the next three years of estimated dividends, reinvested:

Not too bad. I've increased my income from about $1869 per year to $2377.91 or a bit more than 27%. In today's work environment, a 27% raise over three years would be pretty amazing!

Adding Covered Calls to the Mix

As many of you know, I like to sell covered calls for additional income. Since we won't actually need that extra income (or at least not all of it) for the next three years, what would happen if I sold calls on a quarterly basis and used the premium to purchase additional shares?

The assumptions here are all the same as the first table with the addition of the option premium. That column is simply what my net premium per share was when I rolled out in January, rounded down slightly.

In reality, I'd never buy small numbers of shares each quarter unless I had a bunch of free trades. I'd accumulate cash until I had enough to buy in round lots (i.e. multiples of 100 shares). That will slow the growth somewhat, though not a lot due to the relatively small number of shares involved each quarter.

Taking this approach, my annual income from dividends alone climbs to $3056 after three years or about another 28% higher than DRIPing alone. Income from option premiums is now $4080 per year for a total income of $7136 or about $594 per month.

Can This Be Made Better?

I laid this out on a quarterly basis to make it simpler to compare to traditional DRIPing. Selling calls on a monthly basis will in many cases increase income somewhat and provide some significantly greater flexibility in the event the underlying must be sold to raise cash in an emergency. Many equities also have weekly options as well. Obviously, writing more frequently requires more work and increases overall transaction costs.

What Does It Mean?

On a "Fill the Gap" basis that amount would more than cover three major monthly costs: two mobile phones, FiOS (cable, landline, internet), and our gas and electric bill from PECO which combined total $574. We're planning to drop the land line and go to a "skinny bundle" when the current FiOS contract expires in a few months, so we can easily use those savings for the last utility, water & sewer, which is about $50 a month ($35-$40 for water, $15 for sewer).

This single position plus my Social Security at age 66 (estimated at $2536 monthly) will more than pay for housing (currently $1,675), utilities (see above), and food (we spend about $400 a month on groceries). That's a lot of bang from a single position.

Now we all know about ASSumptions and there are plenty in this little exercise, but I don't think they're especially outlandish.

What Could Go Wrong?

A few possibilities include:

HCP could suffer some sort of failure and slash the dividend

We might come into a long period of reduced volatility, decreasing option premium

HCP could "run" making it necessary to skip a quarter in order to roll out at a net credit.

Number one was frighteningly close to happening when news of the HCRMC debacle broke. Fortunately, HCP management was pretty nimble and managed to negotiate a pretty reasonable arrangement. The February 9 earnings report should provide more insight into the situation.

Number two, low volatility, doesn't look likely, at least in the immediate future. Whatever the environment in the future, we'll have between eight and ten well-diversified positions by the time we're both retired so (gods willing) we won't be critically dependent on any specific underlying.

The third possibility, a price run, has happened to my position and in fact, I have had to roll out for relatively meager premiums a couple times with this stock.

Fortunately, there are a number of ways to work past this situation including writing more distant expirations, letting the position be assigned and writing CSEPs, or even (gasp!) accepting a debit to gain a higher strike price.

This last is obviously sub-optimal but by stretching out in time, it's sometimes possible to end up with a $2.50 increase in the strike for less than $1.00 net debit.

Coming up for HCP

On February 9, they'll announce fourth quarter results. At that time, we should get some details about the lower than hoped/expected dividend bump and more information on the HCRMC issue and the status of the divested properties.

Disclosure:I am/we are long HCP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.